Endogenous Borrowing Constraints and Consumption Volatility in a Small Open Economy

Consumption volatility relative to output volatility is consistently higher in emerging economies than in developed economies. One natural explanation is that emerging economies are more likely to face borrowing constraints and, as a consequence, find it more difficult to use international capital markets to smooth consumption. The author investigates how much this mechanism alone can account for the relative consumption volatility differential between emerging and developed economies. His theoretical approach relies on a standard dynamic general-equilibrium model of a small open endowment economy that is subject to an endogenous borrowing constraint. The borrowing constraint makes the small economy exactly indifferent between two options: (i) repaying its external debt, or (ii) defaulting and having to live in financial autarky in the future. The model for the constrained economy is calibrated to match Brazilian data during the period 1980-2001. The author's findings suggest that the model is capable of accounting for more than half of the observed relative consumption volatility differential.